Penny stocks may sound enticing but do you know what penny stock are and how they work? Find out if these riskier investments are right for your portfolio.
So you've recently overheard someone talking about penny stocks and the massive gains they made on their investment and now you want a piece of the action. While these stocks may sound appealing, they are certainly not for everyone. Before jumping into buying for your first penny stock, it is important to understand what penny stocks are and exactly how do penny stocks work.
What is a penny stock?
A penny stock is a riskier, more speculative type of investment where shares of these companies are trading at less than $5 per share. These stocks often trade on pink sheets or over-the-counter bulletin board (OTCBB) and are regulated by the Securities and Exchange Commission with specific rules to follow.
Penny stocks not only have multiple terms, they also have multiple accepted definitions. Although sometimes referred to as penny shares or micro-cap stocks, the latter is often associated with a company's smaller market capitalization (between $50 and $300 million) while penny stocks are categorized by their per share price. While a common acceptance of a penny stock are those trading at less than $1 per share, the Securities Exchange Commission defines penny stocks as those trading under $5 per share. Penny stocks are mostly found outside of the major market exchanges, however, companies on major exchanges with lower stock prices are also sometimes referred to as penny stocks.
How penny stocks work?
Penny stocks essentially trade like any other stock while carrying added risk. With lower volume, penny stocks trade hands less frequently making these investments less liquid. Penny stocks are also susceptible to higher price swings, all of these factors make penny stocks dangerous investments.
Due to their lower per share price and smaller market capitalization, penny stocks carry increased risk and are made up of highly speculative, unproven companies. With less coverage from large institutional investors, these stocks offer less information making it tougher to make sound trading decisions. Because they are not required to file with the SEC, the information that is available is often less credible. Penny stocks are also regarded as illiquid investments with less shares of these companies trading hands every day. Less liquidity increases the chances of not finding a buyer and being forced to sell at unwanted prices. Additionally, these companies are often the subjects of price manipulators who will purchase large quantities of a stock, then artificially inflate the share price through false and misleading positive statements (known as pump and dump).
Are Penny Stocks Worth it?
Penny stocks can be worth it if the investor fully understands the risk that these securities carry. The investor should only use money that they are prepared to lose and make sure that this investment fits into the strategy of a diversified portfolio. Penny stocks must be navigated with extra due diligence and caution.
Investors should set realistic expectations when purchasing penny stocks recognizing that the odds are usually against them. The buyer must also be prepared for the potential large losses that can occur from these investments. Before buying these types of stocks, ensure that you have amassed a core group of solid companies in your portfolio and make sure that these speculative stocks are only a small fraction of your investments. Before purchasing penny stocks, get used to how they trade with Wall Street Survivor's stock market game and ensure that penny stocks are the right investment for you.
8 Things you should know about penny stocks
They are risky
They carry more risk than regular stocks because of their lower prices per share and higher volatility. Because these are highly speculative investments, they are certainly not for everyone.
They offer less liquidity
There is a much lower volume of shares trading hands everyday. When fewer shares are being sold, any significant purchase or sale may push the stock to higher or lower levels. Less volume also means the investor runs the risk of not being able to sell their shares at their desired price.
They have small market capitalization
Hence the term micro-cap stocks, their market capitalization is usually in the range of $50-$300 million. This is the result of a low price per share paired with a low number of shares outstanding.
There is less information available
This makes it tougher to make sound investment decisions. There are less ratios, reports and fundamentals available and much of the information that is available is rarely from credible sources.
They are volatile
Extreme price swings can happen weekly or even daily as these stocks are very news sensitive. Traders rarely buy these stocks for their strong fundamentals but rather for the potential of an important new product release, for example the next big pharmaceutical drug.
When critical news is released, share prices will experience excessive swings in relation to the confidence of the news.
They can be manipulated
Poor liquidity and lack of information make them susceptible to price manipulators who will first purchase a large quantity of the stock, then artificially inflate the share price through false and misleading positive statements. Scammers will use various media platforms such as newsletters, television or online articles to promote “the next big stock”.
They lack history
If they are newly formed companies, there is no price history and if they are approaching bankruptcy they will generally have a poor track record. Yes, past performance is no indication of future performance, but it is certainly helpful.
The SEC watches them closely
Sometimes the SEC will even impose trade halts on these stocks if the price spikes too dramatically and suspiciously for further investigation. The stock may continue to rise or fall while halted leaving the investors with no control and open to potential significant losses.
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